United Nations: Diversification crucial to reduce risks in commodity sector

Published on Wed, 2019-05-08 21:02

Diversification, in addition to an effective risk management strategy, remains crucial for commodity-dependent developing countries in order to increase resilience and reduce macroeconomic risks related to the commodity sector.

This is one of the main conclusions highlighted by the UN Conference on Trade and Development (UNCTAD) in a Secretariat Note presented at the eleventh session of the multi-year expert meeting on commodities and development.

UNCTAD said that at the macro-level, in addition to strengthening risk management, reducing commodity dependence through diversification of production, exports and revenue sources remains the most straightforward way to increase macroeconomic resilience and mitigate risks related to international commodity markets.

Similarly, fighting poverty and raising the incomes of the most vulnerable groups of society, in line with the Sustainable Development Goals, is crucial to strengthen economic and social resilience at the micro-level, it added.

Commodity dependence a huge issue

In some opening remarks at the expert meeting, Ms Isabelle Durant, Deputy Secretary-General of UNCTAD, said 67%, or 91 out of 135 developing countries, depend on commodities, a situation that has sadly not shifted over the last two decades.

The percentage is even higher among the Least Developed Countries (LDCs), with 80% of these countries falling within the commodity-dependent category.

It is a huge issue for a very large number of developing countries. Heavy dependence on commodities makes these countries vulnerable to shocks and price fluctuations, she said.

Ms Durant explained that the ongoing fall in commodity prices since they peaked at the start of the decade affects the ability of countries dependent on these few products to actually ensure their socioeconomic development.

The collapse of export revenues has affected not only state budgets but also that of households producing farm products such as cocoa, tea and coffee, she said.

Reduction of commodity price volatility through horizontal and vertical diversification is the most secure and safest way of reducing vulnerability, Ms Durant said, adding that only export diversification and diversifying the economy can lead to sustainable development.

Highlighting some recent trends in the commodity markets, Mr Janvier Nkurunziza, chief of the commodities branch at the UNCTAD Division on International Trade and Commodities, said that as in previous years, commodity prices were volatile in 2018. However, they generally followed a downward trend, with variations between commodities.

Overall, agricultural products witnessed falling prices, a trend that began when the most recent commodity boom ended in 2011, while mineral prices dropped after an upturn in 2016 and 2017 for ores such as gold, nickel and zinc.

However, the prices of crude oil and natural gas fuels were the exception in 2018, said Mr Nkurunziza, adding that the price index for energy products increased, particularly from its low level in 2016.

As a result of the downward trend of most commodity prices, countries have been losing crucial import and export revenues.

"The continued fall in commodity prices since their peak in the early part of the decade has affected the ability of countries dependent on these commodities to ensure their socio-economic development," said Mr. Nkurunziza.

Volatility in commodity markets

According to the UNCTAD Secretariat Note, commodity markets are volatile and therefore constitute a source of risk and uncertainty for those that depend on them. In this regard, risks emanating from the commodity sector affect all actors in the commodity sector.

This includes Governments of commodity-dependent developing countries, exporters, traders and commodity producers, such as smallholder farmers, all of whom can benefit from effective risk management.

The nature, scale and potential impacts of risks to which Governments and various private sector actors are exposed vary.

Therefore, the optimal choices of instruments and strategies for risk management can be expected to differ between and across different stakeholders.

According to UNCTAD, there are a range of instruments and strategies that can be used to mitigate risks emanating from the commodity sector.

It said these include financial instruments to hedge commodity price risk, fiscal buffers to absorb shortfalls in commodity revenue and commodity-linked bonds to reduce the risk of debt distress in the wake of commodity price shocks. Local commodity exchanges can also provide risk management services to commodity producers and traders.

It is important to note that there is no panacea to risk management in commodity markets, said UNCTAD.

In practice, Governments, producers and traders of commodities need to evaluate costs and benefits of available risk management tools and calibrate their individual risk management approach accordingly.

Commodity markets feature a range of risks. Consumers and producers of commodities are subject to price risk, which refers to the uncertainty regarding future commodity prices. Uncertainty regarding agricultural yields or mining output gives rise to production risk.

The delivery of commodities from producers or traders to consumers is subject to transportation risk. As in all areas of trade, counterparty risk also affects commodity transactions.

Currency risk exists when commodity trade takes place across countries with different currencies and when transactions must be settled through currency conversions.

The former is particularly important for commodity producers and Governments of commodity-dependent developing countries, while the latter poses a constant threat to the livelihoods of smallholder farmers.

According to UNCTAD, commodity prices are characterized by a high degree of volatility. For instance, between September 2008 and September 2018, the average spot price of Brent crude oil fluctuated between $124.9 and $30.8 per barrel.

Similarly, the average monthly price of copper at the London Metal Exchange fluctuated between $9,868 and $3,072 per ton during the same period.

Agricultural prices have also been volatile. For example, between September 2008 to September 2018, the average monthly indicator price of the International Coffee Organization reached a high of 231 United States cents per pound, and a low of 98 United States cents per pound.

In terms of commodity groups, minerals, ores and metals have been the most volatile group, as measured by the coefficient of variation of monthly indices since 2000, followed by fuels, then food and agricultural raw materials.

Past initiatives to control commodity price volatility included the establishment of international commodity agreements for commodities, such as sugar, coffee, cocoa and natural rubber in the 1960s and 1970s.

A key objective of international commodity agreements was to stabilize commodity prices through export quotas and buffer stock interventions.

In the 1980s and 1990s, international commodity agreements were dismantled or ceased to intervene in the market, in line with a global trend favouring price liberalization and the free play of market forces.

During the same period, many agricultural marketing boards and other agencies that aimed at stabilizing commodity prices at the national level were abolished or scaled back their activities.

Moreover, after its creation, the Common Fund for Commodities was poorly funded and unable to substantially help commodity-dependent developing countries to stabilize their commodities prices as originally intended.

For Governments of commodity-dependent developing countries, where public revenues depend to a large extent on commodity exports, this constitutes an enormous challenge.

An accurate forecast of future revenue is essential for the financial planning of expenditures and investments.

Consequently, in the presence of uncertainty due to price risk, there is a threat to the sustainability and continuity of public development programmes.

This in turn creates a risk for the achievement of the Sustainable Development Goals in commodity-dependent developing countries.

Another key source of risk that affects particularly farmers in developing countries relates to environmental conditions, such as rainfall patterns.

Smallholder farmers are especially vulnerable to unfavourable weather conditions and weather-related natural disasters that can threaten their revenue as well as food security.

In the absence of insurance, weather-related shocks can have significant impacts on the livelihoods of farmers, their families and rural communities that are often highly dependent on agriculture.

According to UNCTAD, there are various financial instruments, also known as derivatives, which can be used to hedge commodity price risk. Broadly, these instruments consist of futures, forward contracts, options and swaps.

While about two thirds of developing countries are commodity dependent, the use of financial instruments to hedge commodity price risk is not widespread among Governments.

However, there are some cases where Governments of commodity exporters or State-controlled companies have used financial instruments to manage commodity price risk.

For instance, the Government of Mexico has hedged its oil export-related revenue since 2000 and spent $1.25 billion on put options in 2017 to lock in prices of oil exports for 2018.

Another example is the Brazilian State-controlled oil company Petroleo Brasileiro that spent $445 million on put options to secure a minimum price of $65 per barrel for part of its oil output in 2018.

Ecuador engaged in an oil hedge involving put options and a swap in 1993 that resulted in costs of $20 million, causing political turmoil that led to the end of the country's oil hedge.

Financial instruments have also been used by commodity-importing countries to hedge against price risk.

Panama has been hedging its oil imports through call options since 2009, in line with its National Strategy for Hydrocarbons Risk Hedging.

Uruguay bought call options to hedge 6 million barrels of oil, corresponding to about half of its annual oil imports, over a period of 12 months starting in mid-2016.

"Like all insurance products, financial instruments carry costs, which need to be carefully weighed against their potential benefits," said UNCTAD.

UNCTAD said the purpose of financial instruments in the context of risk management is to mitigate exposure to price risk rather than to speculate on potential favourable price movements.

Therefore, it seems that countries have had better experiences with financial instruments, embedded within a clear risk management framework and used over a long time period.

Commodity exchanges are regulated market places where commodities, and often commodity derivatives, are traded.

In this regard, commodity exchanges fulfil several important functions. These include price discovery, risk management and facilitation of commodity trade.

Furthermore, many commodity exchanges make important physical infrastructure available, such as warehouses and cold storage facilities, that might not be in place without those commodity exchanges.

UNCTAD said that in the context of risk management, commodity exchanges can help commodity producers and traders in commodity-dependent developing countries to manage price risk and other sources of uncertainty, such as counterparty risk and quality risk.

There are many factors that can hinder the participation of commodity producers and traders in international commodity exchanges.

For instance, smallholder farmers often do not have the information, technical skills or access to foreign currencies needed to participate in trading on foreign commodity exchanges.

Also, traders and exporters based in developing countries might face regulatory, financial or other obstacles that limit their abilities to access commodity exchanges outside their countries. Furthermore, market participants based in developing countries cannot directly benefit from physical infrastructure services, such as warehouses from commodity exchanges that are based abroad.

Commodity exchanges in developing countries can play an important role in filling this infrastructure gap, said UNCTAD.

The largest and most sophisticated commodity exchanges outside of developed countries are in emerging economies, it noted.

These include the Brasil Bolsa Balcao in Brazil; the Rosario Board of Trade in Argentina; the Multi Commodity Exchange of India and the National Commodity and Derivatives Exchange in India; the Dalian Commodity Exchange, the Shanghai Futures Exchange and the Zhengzhou Commodity Exchange in China; the Bursa Malaysia; and the South African Futures Exchange.

According to UNCTAD, commodity exchanges can only be effective and successful if certain pre-conditions, including an appropriate regulatory and legal framework, and physical infrastructure needs are met.

In this regard, commodity exchanges that are well designed and respond to the needs of potential users can lower the transaction costs of commodity trading and help commodity producers, traders and exporters to manage risks.

Commodity price-related risks can be reduced by accumulating savings during periods of high commodity prices in order to enhance economic resilience and stabilize public finances during times of low commodity prices.

In this regard, many resource-rich countries have established sovereign wealth funds, through which parts of commodity revenues are set aside.

Commodity-funded sovereign wealth funds can have a range of policy objectives, including the stabilization of the budget in the wake of commodity price swings (stabilization funds), the accumulation and transfer of wealth to future generations (savings funds) or a combination of multiple objectives.

For instance, the Norwegian Oil Fund, which is the largest commodity-linked sovereign wealth fund, with more than $1 trillion worth of assets under management, serves as a savings fund but also helps to finance the non-oil budget deficit.

In the context of risk management in commodity-dependent developing countries, both stabilization funds and savings funds can play a role, said UNCTAD.

Stabilization funds help to shield the annual budget from shocks arising from volatility of commodity revenue. The existence of stabilization funds in resource-rich countries has been shown to reduce volatility of government spending. This strengthens the sustainability and continuity of public development programmes.

Furthermore, stabilization funds can support the implementation of countercyclical fiscal policy rules.

The drop in commodity prices after the boom period of the 2000s has underscored the importance of an effective fiscal policy framework for commodity-dependent developing countries, said UNCTAD.

This includes the provision of fiscal buffers, i.e. savings in the form of liquidity or liquid assets, to manage risks and uncertainties from commodity price shocks and volatility.

Such fiscal buffers are not only a means of self-insurance against negative commodity price shocks but can also help to carry out countercyclical fiscal policy and limit the growth of external debt during times of falling commodity prices.

Commodity price fluctuations and shocks will always be a source of risk for the balance sheets of commodity- dependent developing countries.

However, managing this risk through precautionary saving and a robust fiscal policy framework can limit the extent of negative impacts emanating from unfavourable developments on international commodity markets, said UNCTAD.

It noted that many commodity-dependent developing countries have accumulated significant amounts of external debt during and after the commodity price boom of the 2000s.

These debts constitute a major source of risk for governments of commodity-dependent developing countries.

In particular, when the budget depends to a large extent on commodity revenue there is the risk that falling commodity prices increase the relative burden of debt service payments and thus shrink the government's policy space.

For instance, debt service as a share of gross national income fell, on average, for African commodity-dependent developing countries between 2000 and 2010 but has increased every year ever since.

One way to reduce this risk is to use debt instruments that are linked to commodity prices, said UNCTAD.

There are several possible reasons why the market for commodity-linked bonds is under-developed, it added.

For instance, as there is no existing liquid market for commodity-linked bonds, investors might be reluctant to buy these instruments or ask for high risk premiums.

Also, Governments of commodity-dependent developing countries might have concerns about potential political backlash due to rising debt payments during times of increasing commodity prices.

These real and perceived costs would need to be weighed against the potential benefits of commodity-linked bonds in the context of sovereign risk management and countercyclical fiscal policy in commodity-dependent economies, said UNCTAD.

UNCTAD also said in order to cope with uninsured weather-related shocks, farmers often resort to a range of strategies that are inefficient as well as problematic from a development perspective and can have long-lasting negative effects.

For instance, in the event of a crop failure caused by drought, some farmers could be forced to sell productive assets such as livestock or farm land, which diminishes their longer-term income opportunities.

Furthermore, a farmer and a farmer's family can be pushed into poverty if the household's pre-shock income was close to the poverty threshold.

Other disadvantageous shock-coping strategies consist of reducing spending in critical areas, such as education and health or decreasing food consumption.

Such shock responses carry negative impacts for child development, health and educational attainment, which affect productivity and earnings potential over the long-term.

Thus, there are numerous potential benefits that can be obtained through the development of suitable insurance products.

The experience with index-based weather insurance so far has shown that these schemes have an impact on the production decisions and risk-taking of previously uninsured farmers.

Beyond helping farmers to manage weather risk, these schemes can also generate co-benefits in terms of facilitating access to credit, as insurance reduces the risk of default.

There are, however, also many operational issues that have surfaced. Most notably, low uptake has limited the impact of index-based solutions.

Several reasons for low uptake of index-based weather insurance among farmers have been identified, said UNCTAD, pointing among others to basis risk, credit constraints, missing regulatory framework and lack of information, organizational capacity and trust.

It has also been argued that smallholder farmers have difficulties paying insurance premiums.

The design of index-based insurance products needs to address these challenges to be scalable and sustainable, i.e. commercially viable beyond a pilot phase.

Going forward, said UNCTAD, the impacts of climate change could add to weather-related risks, which would reinforce the need for effective and accessible risk management tools to secure rural livelihoods, ensure food security and fight poverty.